The Reserve Bank of India's monetary policy statements ever since the framework was changed from monetary targeting approach to multiple indicator approach since April 1998 contained three important elements.

First, was an assessment of macroeconomic and monetary developments in India in the backdrop of global developments.

The second is the stance of monetary policy which clearly presented whether the policy's thrust was biased towards the price stability or inflation control objective or more attuned towards supporting growth by stimulating investment and export demand; and third was policy action in terms of monetary measures using instruments such as cash reserve ratio, repo rate and reverse repo rate.

The policy statements provided base line projections for growth and inflation, besides some monetary and banking indicators.

Another important element of policy had been the strategy towards exchange rate and the closely related reserves management which practically did not undergo any change till late 2009.

The exchange rate policy was guided by the broad principles of careful monitoring and management of exchange rates with flexibility, without a fixed target or a pre-announced target or a band, coupled with the ability to intervene, if and when necessary.

The management of reserves took into account the changing composition of the balance of payments and endeavoured to reflect the ‘liquidity risks' associated with different types of flows and other requirements.T his strand of policy presentation and prescription by and large continued through the tenures of Dr. Bimal Jalan and Dr. Y.V. Reddy till about end of 2008 and extended through the tenure of present Governor Dr Duvvuri Subbarao till about the end of 2009.

Some Recent Departures

Three broad departures are evident since about late 2009. First, while the macro and monetary projections continue, the upside and downside risks are elaborated in the statement.

Second, over a period, the policy statements now provide a forward guidance to policy stance. Earlier, there was no policy guidance for the immediate future except stating broadly that the RBI would act swiftly and decisively as and when evolving external and domestic conditions so warrant.

Third, while the reserves management strategy did not seem to have undergone a change, the exchange rate management had become more and more fully market-oriented and the RBI has been following practically a hands-off policy.

Two implications are evident because of the recent changes. First, the surprise element has been taken out of policy to a great extent. Apparently, almost every policy change was anticipated and discounted invariably by markets even before the announcements. One exception was a 50 bps hike in the repo rate last July when the anticipation was only for a hike of 25 bps.

Second, the exchange rate movements are now in a wider range, particularly under global uncertainty. Third, in the absence of exchange market intervention, the extent of reserves accumulation has been limited.

Implications of guidance

In the mid-year review, the forward guidance of a pause by December seems to have virtually negated the policy action of raising the policy rate.

The market seemed to have cheered the guidance. The stock prices moved up and the government securities yields have softened, soon after the policy announcement.

In corporate bond market also, yields are reported to have fallen sharply as some buying emerged. Given the easy liquidity scenario, the transmission of the rate hike on base rate and effective bank lending rate is also likely to be muted.

The second risk is about inflation. Even assuming oil prices rule stable, a currency depreciation has serious downside risk to inflation forecast.

Added to this is the fiscal risk that may put added pressure. Late 2009, both government and the RBI anticipated the inflation rate to come down significantly by end of fiscal and this was belied later. If for some reason, the inflation rate does not subside by December, there would be a loss of credibility.

Third, once the market knows about hands-off policy of RBI on exchange market intervention, any intervention when really warranted by RBI may not be taken seriously and may prove to be excessively costly even for moderating volatility in rupee exchange rate.

Dr. Reddy, who was known to have taken the market often by surprise, mentioned in an important speech on communication in 2008 that surprise element in the decisions and timing of the communication were more effective, and particularly when the public policy preferences and the market preferences were in virtually opposite directions.

He added that the emphasis of communication was on presenting information and analyses, while the RBI desisted from giving any explicit forward guidance.

A transparent signal for stabilising expectations in tune with policy stance would enhance policy transmission.

But, such signals are better given through actions from time to time, but not by declaring in so many words about the actions that would be taken or not taken in the future.

As such, when policy action is hawkish, a dovish forward guidance on policy may negate the very objective of current policy action.

(The author is Director, EPW Research Foundation. These are his personal views).

Related Topics